China Unpegged?

Despite China’s move last week to devalue its exchange rate, the yuan is still materially stronger against most currencies.

What is crucial is whether this move is followed by further depreciation or additional easing efforts. A 10% move on the yuan would remove recent valuation froth.

The asset allocation implications of an orderly weakening of the Chinese currency appear bullish for both bonds and equities.

Last week’s easing announcement from the People’s Bank of China (PBoC) brings the first formal devaluation in the yuan (CNY) exchange rate since January 1994. In isolation, this move is insignificant. The adjustment back in 1994 was about 50%, compared to about 4.5% in the latest devaluation.* Furthermore, the yuan is still materially stronger against most currencies — for example, it has only just closed the gap that opened up against G10 exchange rates since mid-July, and has appreciated vs. Asian and EM currencies over this period (Exhibit 1). Over any longer time horizon — three months, six months, a year or several years — it is difficult, if not impossible, to argue that the yuan has done much at all (Exhibit 2).

Exhibits 1 & 2: The yuan only just closes the four week gap vs. other currencies. Over longer time periods, the yuan has done very little (all baskets are equally weighted).

Of course, what is crucial is whether this is followed by further depreciation or accompanied by other additional easing efforts. The PBoC statement accompanying the decision and subsequent press conference both presented the depreciation as a means to “fix the persistent discrepancy between the reference rate (i.e., the daily fixing) and actual spot rate in the market.” This could be a response to the IMF’s prompt the previous week to allow a greater role of market forces in the yuan ahead of the Special Drawing Rights review, or to the latest soggy trade data — or some combination of the two.

The spread between spot CNY and the fixing narrowed dramatically over the course of the week. While this is exactly the desired result, it also highlights the central role played by the Chinese policymakers in setting the currency rate. To be sure, last week saw heavy official selling of U.S. dollars near the market close each day, and a few media reports suggest that the central bank had instructed local banks not to allow any large forex transactions. We are also none the wiser on how the daily fix is computed — how many market makers quotes are taken into account, what weight is assigned to liquidity conditions, and so on. The PBoC, so far, retains full control.

Exhibit 3: The yuan weakens — but the fixing is key

While it is difficult to make a clear call on the next move, strong overvaluation in the yuan, deep economic weakness and repayment of foreign loans by Chinese corporates in Q1 and Q2 would argue in favor of greater currency weakness and ahead of what forward FX rates currently price.

The green dots in Exhibit 4 show the “live” real effective exchange rates (REER) across a range of EM currencies, taking the latest BIS data (in this case, June) and updating it for spot moves to Friday evening. The “whiskers” indicate the maximum (purple bar) and minimum (grey bar) reached between 1994 and 2013. The yuan sticks out like a sore thumb: it is the only currency in EM that is outside these bands, and it is also the richest on this basis across the EM universe. Note: for the yuan to move back into its historical range (i.e., for the green dot to fall to the purple bar) would require a further 8.5% depreciation.

Exhibit 4: Yuan is the most overvalued currency vs. its own history and other EM

On the economic front, data has been more mixed recently, with weakness in trade contrasting with some signs of stabilization in the property sector, monetary data, and the broad Li Ke Qiang indicator of economic activity. Yet for all the talk, the Chinese economy remains resolutely export-driven, and the yuan has strengthened meaningfully versus all of its trading partners. Furthermore, China’s unit labor costs have increased by a third since the GFC against a relative reduction in costs for its competitors. So a weaker currency would help boost competitiveness.

Finally, while there has been a lot of commentary on capital outflows from China — which according to some estimates are 6–7% annualized as a percentage of GDP thus far — our sense is that it might not all be bad news. Data from the BIS show a sharp contraction in foreign loans (i.e., repayment) in Q4 2014 and Q1 2015, which incidentally, matches exactly the losses in foreign exchange reserves over the same period (Exhibit 5). Less overseas debt in foreign exchange clearly opens up room for some currency weakness, bearing in mind that greater competiveness should also help the cash flow situation for the chief borrowers, the state-owned enterprises (SOEs).

The asset allocation implications of a weaker Chinese currency depend to a large extent on how significant it is and whether we get other forms of easing in tandem. As things stand, our expectation would be a piecemeal approach — involving a combination of reserve ratio requirement (RRR) cuts, FX weakening and other stimulus measures. The scope to ease via both policy rates and the currency remains significant; relative to past easing cycles, policy remains tight. An easing involving, say a 10% total depreciation of the yuan, would comfortably exceed market expectations and reduce a significant headwind to China’s export recovery. On balance, we think this would be bullish for both risk assets (by reducing fears of a hard landing for China) and core government bonds (by exporting deflation).

*This refers to the move in the central fixing since Tuesday. The move in onshore spot, which is allowed to deviate by up to 2% from the fixing each day, was a bit less.